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Export and Strategic Currency Hedging

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Abstract

This paper examines an international Cournot duopoly wherein a home firm and a foreign firm compete in the home market under exchange rate uncertainty. The foreign exporting firm, being risk averse, has incentives to hedge its exchange rate risk exposure. In a two-stage setting, we show that hedging via an unbiased currency futures market acts as a strategic device. In particular, under either constant or decreasing absolute risk aversion, an increase in the hedging volume of the foreign firm promotes its exports and deters the home firm’s output. In contrast to the well-known full-hedging result in a perfectly competitive environment, we find that the foreign firm over-hedges for strategic reasons. Furthermore, the separation result from the hedging literature under perfect competition no longer holds in our duopoly framework, i.e., equilibrium output levels depend on the risk attitude of the foreign firm as well as the probability distribution of the spot exchange rate.

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Notes

  1. See, e.g., Benninga et al. (1985), Broll and Zilcha (1992), Broll et al. (1995, 1999), Friberg (1998), Wong (2003a, b, 2006) and Broll and Wong (2006).

  2. For recent work see, e.g., Kirman and Phlips (1996) and Hens (1997).

  3. Our model applies equally well to a broader case that the foreign firm competes in a world market where the home currency is the standard invoice currency. We thank an anonymous referee for pointing this out.

  4. Throughout the paper, a tilde (~) signifies a random variable.

  5. In a setting of two-way trade in both countries, the risk preferences of the home and foreign firms become crucial because both firms are now exposed to the exchange rate risk. Our results may not be robust to this symmetric scenario.

  6. For any two random variables, \(\tilde{X}\) and \(\tilde{Y}\), we have \({\rm Cov}(\tilde{X},\tilde{Y})={\rm E}(\tilde{X}\tilde{Y}) -{\rm E}(\tilde{X}){\rm E}(\tilde{X})\).

  7. See Collie (1992) for a detailed discussion of the existence and uniqueness of the Cournot-Nash equilibrium in models of international trade under oligopoly. See also Wong and Chow (1997).

  8. In a rather different vein, Hughes and Kao (1997) show that if forward transactions are not observable and if hedging motives are not present (i.e., firms are risk neutral), the strategic incentives identified by Allaz (1992) and Allaz and Vila (1993) no longer exist.

  9. This outcome is observationally equivalent to the benchmark equilibrium considered in Section 3.

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Acknowledgements

We would like to thank George Tavlas (the editor) and an anonymous referee for their helpful comments and suggestions. The usual disclaimer applies.

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Authors and Affiliations

  1. Faculty of Business and Economics, Dresden University of Technology, 01062, Dresden, Germany

    Udo Broll

  2. Department of Economics, University of Augsburg, 86135, Augsburg, Germany

    Peter Welzel

  3. School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong, China

    Kit Pong Wong

Authors
  1. Udo Broll
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  2. Peter Welzel
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  3. Kit Pong Wong
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Correspondence to Udo Broll.

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Broll, U., Welzel, P. & Wong, K.P. Export and Strategic Currency Hedging. Open Econ Rev 20, 717–732 (2009). https://doi.org/10.1007/s11079-008-9080-x

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